R&D Tax Credit Can Help Startups Offset Payroll Taxes

This blog post was previously published on August 15, 2019. It was updated on August 17, 2020. 

Many early-stage companies missing out on potential capital inflow

Four years after its introduction to the R&D tax landscape, the R&D payroll tax credit remains underused by startups. Many early-stage companies in the software, technology, FinTech, aerospace and life science industries, among others, have not taken advantage yet of the credit’s availability and immediate benefit to the bottom line.

The payroll tax credit enables startups to immediately monetize the valuable federal R&D tax credit (Internal Revenue Code [IRC] Section 41) that many entrepreneurs still misconceive as available only to large corporations. However, the truth for startups is that the payroll tax credit is a potential inflow of capital that can reach up to $250,000 per year for a period of five years. This capital inflow can be a substantial boost for startups with little or no taxable income in their first years of activities, but with significant research and development costs.

For many startups, the COVID-19 pandemic has already introduced significant hurdles, from postponed product launches to disrupted rounds of capital raises. In this challenging and uncertain period, the payroll tax credit is a significant opportunity for positive cash flow that startups should not overlook.

Annually, the credit can represent up to 10% of research and development costs paid or incurred in the United States. Those costs include internal wages, supplies, and U.S.-based contractors. For example, a startup with a small team of five software developers dedicated to R&D activities and representing $500,000 in wages could be looking at a credit of $50,000. A biotech with a team of a dozen scientists developing new therapeutics and using chemicals and external labs representing a total $1,800,000 in research and development expenses could be looking at a credit of $180,000.

Eligibility requirements for startups

Startups must satisfy certain requirements in order to elect the payroll tax credit, including qualifying as a Qualified Small Business (QSB). A corporation (including S Corporation) or a partnership, is a QSB if it meets the following criteria:

1. The entity’s gross receipts are less than $5 million in the credit year.
2. The entity has no gross receipts (including interest income) in any year prior to the 5-year period ending with the credit year.

In other words, to qualify as a QSB and elect the payroll credit for tax year 2019, a startup should have less than $5 million in gross receipts in 2019 and no income in 2014 or in any year prior to 2014.

The maximum amount of the R&D tax credit that can be applied toward payroll in a given tax year is $250,000, and a startup can make the election for a maximum of five years. Expenses and activities for which the payroll credit is captured must satisfy all the requirements of the standard R&D tax credit under IRC Section 41.

Tax planning to capture R&D tax credit

Now, more than ever, it is imperative for startups and entrepreneurs to include the R&D tax credit in their tax planning conversations with their tax professional.

Capturing the lucrative credit requires some planning in order to maximize the benefits, avoid pitfalls or erroneous claims, and streamline coordination between the income tax and payroll tax functions. Moreover, taxpayers must make the payroll election on a timely (including extensions) filed income tax return, not on an amended return, making proper planning with tax advisors even more critical.

For startups who were granted an extension to file their 2019 tax return, there is a small window of opportunity to capture the 2019 R&D tax credit and elect to use is as a payroll credit. The credit will be available for use in the first quarter following the filing of the tax return.

Contact me or another Kaufman Rossin tax professional to learn more about the R&D tax credit and how startups can use it to offset payroll taxes.